Frontier Advisors has suggested its clients, mainly big super funds, include hedge funds in their consideration of portfolio insurance options, widening a brief that the consulting firm started early last year. This follows a ‘normalised’ value for the Aussie dollar and continued low level of sovereign bond yields.
The asset-consulting firm says in its second quarterly report on alternatives and innovation, known as ‘Alt IQ’, that it has been reviewing whether there is a way to use hedge funds solely as a defensive asset, to proxy the role traditionally played by sovereign bonds and foreign currency exposure in a balanced portfolio.
Early last year, Frontier recommended that funds should consider put options over their listed equities as a form of portfolio insurance. The firm has recognized that a put option overlay is not practical for all clients and that some may prefer a funded strategy instead or in addition to.
The two new strategies suggested are: ‘funded tail-risk’ strategies; and, ‘long-volatility’ strategies. Both tend to benefit from a move from low-to-high volatility, which generally occurs when equity markets fall.
Unlike a simple passive approach to put options, the hedge fund managers using these strategies will look to actively manage the portfolio in a ‘left-tail’ event, by taking profits and rotating to new contracts. The long-volatility strategies are designed to kick in earlier than tail-risk hedging strategies but will not deliver as significantly outsized returns in an event such as the 2008 financial crisis would deliver for them both.
Frontier says: “Both strategies will likely exhibit basis risk, given the underlying instruments used are not perfectly matched to the portfolio exposure being hedged (unlike a simple equity put option overlay strategy).
“A key area of focus for both strategies is the need to manage the ‘time decay’. [This] is the reduction in the value of the underlying instruments (typically options) as the chance of a future payoff diminishes as time passes – the closer the option is to expiry, the smaller the chance of a significant equity market fall and the lower the value of the option.”
Frontier notes that these strategies are unlikely to represent a long-term allocation in a well-diversified portfolio primarily because of the time-decay factor.
“However, for portfolios that are currently less ‘balanced’, we believe long-volatility and tail-risk hedging funds, for investors without direct tail-risk hedging in place, are worth further investigation.”